The summer travel season reminds me of family car trips that seem a bit longer on the return home after a vacation. Similarly, the Fed’s extended pause and anticipated arrival at a terminal rate has seemed, well, interminable. At the beginning of the year, markets were starry-eyed children expecting a quick trip (several interest rate cuts). Now they’re just rolling their eyes in the back seat asking, “are we there yet?” as the Fed drives well below the speed limit, willing to get there when they get there.
The second quarter of 2024 was a slow ride extending the longest 2- to 10-year yield curve inversion in history. There were some bumps in the road, as rates occasionally sold off with day-to-day speculation around Fed policy. But the U.S. Treasury market experienced little net change during the quarter, right up to the last trading day of June when the presidential debate steered markets more in the direction of a potential Trump second term. More on that below.
The Bloomberg US Aggregate Index was virtually flat for the second quarter, returning 0.08%, thus leaving the year-to-date at -0.71%, due to rising rates in quarter one. Corporate spreads, for the first time in a few quarters, also had little net change. We attribute that to the overall tightness of a market that has had the soft landing priced in for some time now. First-quarter concerns about economic acceleration and even another Fed hike have abated, and investors, prompted by some signs of economic slowing, appear confident that rate cuts are right around the corner.
Elections outside the US have already stirred up markets, and elections this summer in Europe, the UK and ultimately in the US in November may be more disruptive over the long term.
Downshifting through the corners
The resulting relatively quiet recent market environment has been at least marginally positive for our ‘Alpha Pod’ committees. We’ve been able to add incremental value by staying neutral for the most part on duration, based on the belief that rates would be range-bound, the Fed would be patient, and jobs and inflation data would keep moving in the right direction. Our positioning for a steepening of the yield curve has also been positive, as have sector overweights to emerging market debt and mortgages. We believe our focus on multiple alpha sources, including currency to go with duration, yield curve and sector has helped balance results year-to-date. In what is currently a flat market, we haven’t been alone in beating benchmarks, as the majority of active managers like us have also been able to do that over the past few quarters. But we expect the landscape of the second half of the year to make the drive more interesting and the road potentially rougher along the way.
With markets currently pricing in two rate cuts by year’s end—September, November and December FOMC meetings are in play—and assuming economic data doesn’t surprise, current Fed policy is less of a topic than the potential impacts of national and global politics. Elections outside the US have already stirred up markets here and there, and elections this summer in Europe, the UK and ultimately in the US in November may be more disruptive over the long term.
Which factors will end up driving markets?
In the wake of recent political events, the odds of Republican victories in November have increased materially. A review of the market environment in the month following the November 2016 election reminds us that at the longer end of the curve, bonds sold off 80 basis points, providing another reason to be ready for curve steepening and a possible bear one at that.
The Republicans have campaigned on increased tariffs, limits on immigration and new or extended tax cuts which could impact business investment, job market growth and the size of the US budget deficit. All are potentially disruptive in terms of inflation, financial conditions, the yield curve and policy required by the Fed. The current direction and leadership of the Fed could be on the table as well.
In the background, regardless of the election outcome, is services inflation, which at over 3%, continues to be problematic. A start of an easing cycle in the fall with an important component of inflation at such an inflated level, would be an implicit admission to a point we have been making—that 2.5% or 3 inflation is the new 2%. This has material relevance for long term U.S. Treasury pricing even without the variables of a new administration. Those expecting another Trump term to be stimulative also have to admit it probably wouldn’t help on the inflation front.
All told, we expect that the best current projection for a terminal fed funds rate is somewhere in the 3s, adding an exclamation mark to the higher-for-longer rate environment many of us remember as the norm.
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